New revenue procedure on LIFO recapture yields unexpected result.

The IRS recently issued Rev. Proc. 94-61 to provide long-awaited guidance on how to properly account for the LIFO recapture resulting from a C corporation's conversion to S status.

Sec. 1363(d)(1) states that if an S corporation using the LIFO inventory method was a C corporation for the year prior to the year that the S election became effective, the C corporation must include in gross income the LIFO recapture amount (the amount by which the FIFO inventory exceeds the LIFO inventory) and make appropriate adjustments to the basis of the inventory to reflect the change. This section was enacted to prevent a C corporation from electing S status simply to avoid the built-in gains tax.

It was generally believed that the LIFO recapture amount should be allocated to the preelection LIFO layers based either on the relative base-year cost or the relative LIFO carrying value of the corporation's ending inventory for the last year it was a C corporation. However, Rev. Proc. 94-61 provides that the required method of allocating the LIFO reserve is to "collapse" (combine) the LIFO layers and add the LIFO recapture amount to the corporation's ending inventory for the last year it was a C corporation. However, if the taxpayer has experienced a decrease in its LIFO inventory for a tax year ending before Sept. 19, 1994 (the date the revenue procedure was issued), the Service will accept as appropriate any reasonable method used to allocate the LIFO recapture amount. The procedure further states that collapsing the LIFO layers is appropriate, since the revaluation of ending inventory to FIFO is inconsistent with the LIFO layering approach, and Sec. 1363(d) was enacted to create parity between LIFO and FIFO taxpayers electing to be taxed as S corporations. Accordingly, the required method of allocating the LIFO reserve yields a different result than was expected.

As a result of collapsing the LIFO layers, the LIFO carrying value will be stated at an average cumulative index. Thus, if there is a decrement into a pre-S election year layer, the taxpayer will be treated as selling less expensive goods, thus increasing taxable income (assuming there has been inflation in the preelection years). This point is illustrated by the analysis on pages 27-28 of the allocation method required by Rev. Proc. 94-61 and an alternative method based on the relative LIFO carrying value.

Based on this comparison, a C corporation using LIFO that elects S status may get an unexpected result when there is a LIFO decrement into a pre-S election year layer.

[RELATED ARTICLE]: LIFO Recapture

ABC Company, a C corporation, elected LIFO in 1988. Effective Jan.1, 1992, ABC elected S status. On Dec. 31, 1991, ABC's FIFO inventory valued under the lower of cost or market method was $1,900 and it had a LIFO carrying value of $1,600, comprised of the following layers:

                  Base-year         LIFO carrying
                    cost     Index     value
1/1/88 base year  $1,000     100%    $1,000
12/31/88 layer       200     110        220
12/31/89             --      115        --
12/31/90 layer       100     120        120
12/31/91 layer       200     130        260
Total             $1,500             $1,600

ABC is required to collapse its LIFO layers and add the $300 LIFO recapture amount ($1,900 - $1,600) to the LIFO value of the ending inventory at Dec. 31, 1991. In addition, ABC is required to compute an adjusted index to reflect the relationship between the base-year cost and the new LIFO carrying value. Accordingly, the adjusted index for purposes of valuing future LIFO decrements and the LIFO carrying value are computed as follows.

                   Base-year         LIFO carrying
                     cost     Index     value
1/1/88 base layer    --        100%       --
12/31/88 layer       --        110        --
12/31/89             --        115        --
12/31/90 layer       --        120        --
12/31/91 layer       --        130        --
New layer
pursuant to
Rev. Proc. 94-61   $1,500     126.67%  $1,900

As discussed, prior to the issuance of Rev. Proc. 94-61, many practitioners believed that the LIFO reserve was to be allocated to the LIFO layers based on either the relative base year cost or the relative LIFO carrying value. Both of these allocation methods will produce a more favorable result than the required method when there is a LIFO decrement into a pre-S election LIFO year. (This assumes that there has been inflation in the pre-election years.) The most recent cumulative indices under the alternative methods will exceed the average index used in the required method, and the taxpayer is treated as selling more expensive goods, which will accordingly increase cost of goods sold. For example, if ABC allocated the LIFO reserve based on relative LIFO carrying values, the allocation and revised layers would be computed as follows:

Table 2:
Revised allocation of LIFO reserve:

                   Pre-election                      New LIFO
                  LIFO carrying  Relative  Increase  carrying
                     value        weight   to layer   value
1/1/88 base year  $1,000          62.50%   $187.50   $1,187.50
12/31/88 layer       220          13.75      41.25      261.25
12/31/89             --               0        --         --
12/31/90 layer       120           7.50      22.50      142.50
12/31/91 layer       260          16.25      48.75      308.75
Total             $1,600         100.00%   $300.00   $1,900.00

Revised LIFO layers:

                                           LIFO
                   Base-year  Decrement  carrying
                     cost       index      value
1/1/88 base layer  $1,000      118.75%   $1,187.50
12/31/88 layer        200      130.63%      261.25
12/31/89              --          --         --
12/31/90 layer        100      142.50       142.50
12/31/91 layer        200      154.38       308.75
Total              $1,500                $1,900.00

Thus, if ABC experienced a $200 decrement in terms of base-year
cost in
1992, the required method would increase taxable income by $55 more
than the alternative method:

                        Reduction                Effect on
                       in base-year  Applicable    cost of
  Method used              cost        index     goods sold
Rev. Proc. 94-61
  (Table 1)                $200        $126.67%   $253.34
Based on LIFO
  carrying value
  (Table 2)                 200         154.38     308.76
Increase to income
  resulting from
  requirements of Rev.
  Proc. 94-61                                     $ 55.42